A CONTEXT FOR THE RTSK-BASED REVIEW GIF BANKS
2.4 A Holistic View of the Entire Financial System
established as specialized institutions, banks have sought new customers in wider geographical areas and have come to offer increasingly similar types of accounts, credit, and financial services.
In addition to more intense competition among the different types of bank, the number and diversity of nonbank financial intermediaries have also increased. As a result, effective substitutes for banking products now exist and a broader range of services is available. The threat that non- banking institutions will expand into banking services has likely been another stimulus to banks to adopt market-oriented behavior. Secondary markets have also grown in importance, which has reduced market seg- mentation and created more uniform cost structures for different financial institutions.
Each type of market deals with specific financial products. Innovation has brought about a greater variety of financial instruments, the respective markets of which are continuously increasing. In financial risk manage- ment terms, the understanding of the risk involved in key products offered by a bank and of the implications of specific markets, for example, in terms of liquidity or price stability, is key to being able to adequately
appraise a bank.
As the last block of Figure 2.1 shows, the availability and quality of banking skills is a central concem in the risk-based appraisal of banks. It is essential that banks have good personnel management and that they are able to systematically develop banking skills within their organization. A good bank should be able to acquire the appropriate skills and to develop a suitable work culture. It should also have a process to optimize the mix of staff skills and experience and to develop staff performance levels in concert with its business and institutional goals.
A CONTEXT FOR THE RISK-BASED REVIEW OF BANKS 25
legislation and regulations that are enforced by a supervisory authority.
Several modalities of organizing the supervisory function of different types of institutions exist, but financial systems in most countries are subject to regulations and supervision that delimit the authorized activities and con- duct of financial institutions. The assessment of the pertinent regulatory environment is therefore a major component of bank analysis.
The starting point for analyzing the regulatory environment and its impact on banks is the identification of key laws and regulations and the time at which they were enacted or changed. Many key regulations attempt to encourage banks to manage certain types of risk, such as those related to large loans, currency exposures, investment limits, and related party lending. (A more thorough analysis of such regulations, in the con- text of various types of financial risk, including a discussion of policies adopted by banks in the risk management process, is provided in Chapters 4 through 13.)
As the financial sector has become more complex, regulators have started to pay more attention to qualitative aspects, since rules - particu- larly those based on simplistic quantitative measures - have become eas- ier to circumvent and are more likely to be less than optimal for certain banks. Modem, risk-oriented prudential regulations therefore also include a host of requirements regarding the quality, experience, and skills of bank owners and management (see Chapter 3 for more detail).
It should also be noted that the assessment of whether a particular bank meets a regulator's standards has increasingly become a matter of judgment. Another new area of interest to some regulators involves pru- dential regulations pertaining to key processes in a bank, such as internal audit and internal controls, asset-liability management, and operational risk management. However, in contrast to the control approach taken with prudential ratios, in these areas regulators avoid being overly prescriptive.
Instead, regulations usually specify the philosophy and functional require- ments that have to be met by a bank carrying out a particular process.
Changes in market conditions have also altered regulators' attitudes toward the impact of portfolio structure regulations and other controls on the stability of the financial system. For example, by requiring that port- folios contain certain proportions of liquid and/or low-risk assets, regula- tors have attempted to moderate the negative effects of bank competition
i. Fiscal managementpublic i. Legislative branch policies i. Net reserves
debt management ii. Judiciary ii. IFI reports
ii. Balance of paymemtst iii. Central bank iii. Financial statements currency reserves iv. Corporate policies
ii F n Enani qector trinds v Publir opinion
11. Infrastructure _ _ _.1. Legal and Requstorv Infrastructure 2. Financial Sector Infrastrcture
i. Scope of ii. Licensing iii. Corporate iv. Financial v. Failure and i. Banking ii. Professions iii. Payments iv. Property v. lnfomation
activibes govemance rsk problem and other -Auditors and registnes and
and basis management resolution financial -Actuaries settle- and research
of transacting pnnciples and supervision -Investment ment depositones (rating
defined and closure advisers system -ending/ agencies)
prudential -Securities collateral
requirements tradera -financial
instruments
Ill. Financial t. Banks 2. Contractual Savings 3. Capital Markets/Exchanges
Intermediaries (insurance and pensions)
Secunties Trading and Exchanges Fund Manasement
i. Cooperative ii. Specialized iii. Commercial i. Long-term ii. Pension iii. Short-term i. Secunties trading fimns i. Capital
a. Microfinance a. Savings a. Mutual insurance funds insurance (equities and interest ii. Commodities exchange b. Credit unions b. Agriculture banks -bearng)
c. Housing b. Equity ii. Investment fund
d. Leasing banks _ management firms
IV. Financial i. Fixed-income ii. Equities iii. Currencies iv. Commodities v. Denvatives vi. Other investment funds
Instruments markets a. Usted
and a. Money b. Unlisted
Markets -short-term bills
-commercial paper b. Capital
V. Supervision Super1. e visory uthori 2. Consolidated Supervision 3. Supervisory Cap citv and Monitonng Swtems Central Ministry of Other Systemic rsk i. Administrative ii. Quality of iii. On ste iv. Enforcement
bank Finance -SROs Consumer protection and technical off-site examination capability
Consolidated financial statements structure risk-based and instituton
Synchronization of philosophy monitonng building
systems and analysis
A CONTEXT FOR THE RISK-BASED REVIEW OF BANKS 27
on the financial system and/or to increase the system's ability to withstand shocks. However, given numerous options and the capacity for innova- tion, banks have been in a good position to circumvent regulations and to choose the risk and return profile that they are comfortable with.
Moreover, when banks are prevented from providing financial services for which there is a demand, unregulated institutions, the soundness of which is frequently more questionable than that of banks, may dominate the market, thereby reducing the overall stability of the financial system.
Various authorities often supervise banks and other types of financial institutions. A common arrangement exists whereby banks are supervised by the central bank, the insurance sector and pension funds by the ministry of finance, and capital market institutions by the securities and exchange commission. The various sectors of the financial system interact with the banking system, and vice versa. This sometimes results in the spillover of disturbances from other areas into the banking system. It is therefore impor- tant that regulatory approaches and supervisory practices be coordinated to reduce the probability of negative consequences and regulatory arbitrage.
To be effective in their assessments, analysts and supervisors should not only be able to apply sophisticated analytical tools, but should also be aware of potentially risky developments in other sectors of the financial system and of new trends in foreign banking and supervisory systems. In addition, they should be able to judge the capability and integrity of bank management. Such qualitative evaluations are most effective when they are based on personal contacts and the frequent exchange of views. To this end, a detailed, accurate understanding of bank management can best be obtained through the continuous use of a group of skilled personnel that deals with the same banks over a considerable period of time.
2.5 DisdLosure and UFansparenncy of Banmk lFiniancial nIPnfornmation: A Prerequisite for Risk-Based Analysis
A reliable assessment of the financial condition of banks requires well- trained analysts and supervisors, since many bank assets are illiquid and lack an objectively determined market value. New financial instruments make it even more complex to assess the net worth of banks and other financial institutions in a timely manner. The liberalization of banking and
capital markets has substantially increased the level of information required to achieve financial stability, while the provision of useful, ade- quate information on participants and their transactions has become essen- tial for maintaining orderly and efficient markets. For a risk-based approach to bank management and supervision to be effective, useful and timely information must be provided that meets the needs of each key player (see Chapter 3). In principle, market participants, depositors, and the general public have no less a need for information than do superviso-
ry authorities.
In theory, the disclosure of information can be gradually improved indirectly through peer pressure from powerful parties in the marketplace.
During normal times, such pressure might show banks that disclosure is to their advantage in raising funds, for example, if it prompts potential investors and depositors to provide capital. The desire to hide information
- especially that which conveys poor results - unfortunately often trans- lates into a lack of transparency, which is evident even in economies with advanced banking systems. Furthermore, given the sensitivity of bank liq- uidity to a negative public perception, the information with the strongest potential to trigger sudden and detrimental market reactions is generally disclosed at the last possible moment, usually involuntarily.
Calls for greater transparency often indicate a failure to provide use- ful and timely information, and this is most acute when the information sought or provided is negative. Regulatory authorities have a responsibil- ity to address the availability of information. While banking legislation has traditionally been used as a way to force disclosure of information, this process has historically involved the compilation of statistics for mon- etary policy purposes, rather than the provision of information necessary to evaluate financial risks.
A more direct approach, now practiced by most regulatory authorities, involves mandating minimum disclosure, including a requirement that banks publish specified portions of their prudential reports (which do not reveal information that can be used by competitors) and other pertinent information. The value of disclosure depends largely on the quality of the information itself. However, because the provision of information can be costly, information needs have to be examined closely in order to ensure that the detriments of disclosure are fully justified by its benefits.
A CONTEXT FOR THE RISK-BASED REVIEW OF BANKS 29
Financial disclosure requirements normally focus on the publication of quantitative and qualitative information in a bank's annual financial report, prepared on a consolidated basis and made available to all market participants. The format for disclosure typically mandates a complete, audited set of financial statements, as well as qualitative information such as a discussion of management issues and general strategy. It provides the names, interests, and affiliations of the largest shareholders and nonexec- utive board members and information on corporate structure and also clar- ifies which parts of the financial statements have been audited and which, in supplementary disclosures, have not. Financial statements also contain information on off-balance-sheet items, including quantitative estimates of exposure to shifts in interest or exchange rates.
In addition to minimum disclosure requirements, financial sector dis- closure can be improved by the formnulation of standards on the quality and quantity of information that must be provided to the public. Given the increasing internationalization of banks and the increasing penetration of national banking systems, there is a strong need for minimum standards to ensure the cross-border comparability of financial statements. This responsibility has been taken by the International Accounting Standards Committee, which has developed a set of international standards to facil- itate transparency and the proper interpretation of financial statements.
(Full discussion of transparency and related accountability issues, includ- ing details on international standards, is provided in Chapter 14.)
Disclosure requirements have to be reviewed periodically to ensure that users' current needs are being met and that the burden on banks is not unnec- essarily heavy. Since financial innovations and international influences are likely to expand information requirements, demands made on banks show no sign of diminishing in the future. However, a reliance on full disclosure as a means of monitoring banks requires too much of depositors, who would need an increasing level of analytical sophistication to be able to evaluate the com- plex business of financial institutions. Furthermore, economies of scale exist in the processing and interpretation of financial information. In the future, professional financial market analysts, rating agencies (which are capable of handling sophisticated financial information), and the highly influential media are expected to play an increasingly important role in applying market discipline to influence or to correct bank behavior.